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Forgive me for yet another foray into the vagaries of Tesla, but the company provides your humble blogger with an endless supply of discussion material. (My own prior posts on disparate Tesla-related subjects can be found here, here, and here; Joan Heminway also commented on Tesla here.)

We might say this is different from the Lorenzo case because in that instance, the conduit positioned himself as an employee, passing on information pursuant to his boss’s instruction; Musk, by contrast, apparently chose to single out this particular article; the curation itself may be interpreted as a kind of endorsement.

What if his profile said “retweets are not endorsements”? (At the time of this posting, by the way, it did not.) And – continuing with the fancy that this is a classroom discussion – if you were corporate counsel, would you insist on such a disclaimer?

B. If Musk did make a false statement, was it material? After all, the original false statement was already out there and presumably widely distributed. Moreover, it concerned factual information that was easy to check. In the past, courts have assumed that efficient markets have a heroic ability to self-correct under much more challenging circumstances (see my prior post; see also my forthcoming essay addressing the subject). If reporters’ synthesis of public raw data is not “material” for securities law purposes, see, e.g., In re Merck & Co. Securities Litigation, 432 F.3d 261 (3d Cir. 2005), it’s hard to see why Musk’s retweet of an easily-debunked false news report would be any more significant.

comply with all mandatory procedures implemented by Tesla, Inc. (the “Company”) regarding (i) the oversight of communications relating to the Company made in any format, including, but not limited to, posts on social media (e.g. Twitter), the Company’s website (e.g. the Company’s blog), press releases, and investor calls, and (ii) the pre-approval of any such written communications that contain, or reasonably could contain, information material to the Company or its shareholders.

In brief, Emulex agreed to be acquired by Avago in a friendly tender offer under DGCL 251(h). When Emulex issued its Schedule 14D-9 recommending that shareholders tender their shares, it failed to mention that its bankers found the premium was on the low side as compared to similar deals. The plaintiffs sued, alleging that the omission rendered Emulex’s recommendations misleading in violation of Exchange Act Section 14(e), which prohibits false statements in connection with tender offers. In the courts below, the defendants argued, among other things, that the plaintiffs failed to plead that any misleading statements were made with scienter. On appeal, the Ninth Circuit broke with other circuits and held that scienter is not a required element of a Section 14(e) violation.

Whether the Ninth Circuit correctly held, in express disagreement with five other courts of appeals, that Section 14(e) of the Securities Exchange Act of 1934 supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer.

Note the precise wording here – because we’re going to come back to that.

The dispute begins with the language of Section 14(e):

It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer or request or invitation for tenders, or any solicitation of security holders in opposition to or in favor of any such offer, request, or invitation.

The basic difficulty is that the phrase “make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading” is very similar to that used in Section 11 of the Securities Act, which prohibits misstatements in registration statements, and does not require a showing of scienter. It’s also nearly identical to that used in Rule 14a-9 of the Exchange Act, which prohibits misstatements in proxy materials, and also has generally been interpreted not to require scienter. And it’s pretty much word-for-word the language in Section 17(a)(2) of the Securities Act, which is enforceable only by the SEC and prohibits obtaining money or property by means of untrue statements about securities, and also - you guessed it - does not require a showing of scienter.*

But the phrase “fraudulent, deceptive, or manipulative acts or practices” is very similar to the prohibitions in Section 10(b) of the Exchange Act, which does require a showing of scienter.

14(e) has both! Oh no! Which is it?

Now the interesting thing is, until now, it wasn’t that much of an issue. But then the situation changed.

First, in around 2009 or 2010, you had the great merger litigation explosion; suddenly almost every sizeable merger was being challenged under state law, at least partly (most say) because the collapse of Milberg Weiss left a lot of plaintiffs’ firms hungry for work. Delaware eventually got sick of it and started making it harder to bring state law claims with cases like Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015) and In re Trulia, 129 A.3d 884 (Del. Ch. 2016). Plaintiffs responded by bringing claims under federal law instead. (The stats are documented in The Shifting Tides of Merger Litigation, by Matthew Cain, Jill Fisch, Steven Davidoff Solomon, and Randall Thomas).

Second, in 2013, Delaware enacted 251(h), which created the so-called “intermediate form” merger by making it much easier to structure a friendly acquisition as a tender offer without holding a shareholder vote (a few other states followed suit). Suddenly, the number of deals structured as tender offers spiked.

All of which means that Section 14(e) has been getting more of a workout than it has in the past, leading to new questions about the proper interpretation of the statute.

So what the defendants are really angling for is a declaration that plaintiffs cannot bring claims under 14(e) at all, with a fallback position of, if they can, they have to show intent. (Well, actually, I think the defendants are after something else - but we’ll get there.) And here’s where the rubber meets the road:

When an acquisition is structured as a merger, it will require a shareholder vote, which means the target corporation must circulate a proxy statement. And it was established way back in 1964 that private plaintiffs can bring actions for false statements in corporate proxy materials under Rule 14a-9. SeeJ.I. Case Co. v. Borak, 377 U.S. 426 (1964). As I mentioned, at this point it’s reasonably well established that 14a-9 does not require a showing of scienter.

Meanwhile, acquisitions structured as friendly tender offers (easy to do now under 251(h)) do not require shareholder votes, and thus do not involve proxy statements; the only federal prohibition on false statements comes from 14(e). (And, well, Section 10(b)).

So if the defendants prevail in Emulex - and depending on how they prevail - it could create very different liability schemes for deals structured as mergers rather than tender offers – a difference that is just now mattering a whole lot because of the changes in Delaware law.

Now, the defendants are correct that these days, the Supreme Court finds implied rights of action far less easily than it used to, and when the Court interpreted 14a-9 in 1964, implied rights of action were at their heyday. But unless we’re going to revisit Borak – and literally a 50-plus year understanding of the liability scheme for proxies – it makes no sense to say that plaintiffs are prohibited from suing for misrepresentations in tender offers under 14(e) while still permitting claims for false proxy statements under 14a-9. There are enough artificial distinctions between mergers and tender offers without adding more incentives for deal planners to game out a kind of regulatory arbitrage; indeed, Delaware recently amended the DGCL to create more, not less, similarity between long form and intermediate form mergers. And reaffirming that 14(e) requires scienter while 14a-9 does not may not be as dramatic a move, but it still creates an unnecessary discontinuity.

In any event, if Emulex prevails, I can totally see all kinds of weird results. Like, there are many states that don’t allow intermediate-form mergers, meaning that if you acquire a majority of shares via tender offer, unless you manage to get all the way to 90% or so, you’ll either have to get some kind of top-up or – if you can’t – you’ll have to hold a shareholder vote anyway to complete the deal. In those states, it may make more sense to simply hold a shareholder vote from the outset and skip the tender offer. But if there’s more liability for proxy materials than tender offer materials, acquirers may be tempted to choose a two-step structure anyway: they’ll make the tender offer, obtain enough shares to swing the merger vote, and hold a vote on the back end. That way, they may be insulated from liability for the initial tender offer materials, and – after Virginia Bankshares, Inc. v. Sandberg (1991) – there’s no cause of action for false statements in proxy materials where the outcome is fait accompli.

Or say you need a shareholder vote on the acquirer side – like, to issue more shares. It’s common to just distribute a joint proxy and have both target and acquirer shareholders vote. But if there’s a greater liability risk for proxy materials than tender offer materials, acquirers could intentionally break up the steps and hold a vote of their own shareholders, and then commence the tender offer.

Obviously, all this would be unwieldy and expensive, and if there isn’t another business justification, the choice to avoid issuing proxy statements might function as a confession of intent to commit fraud, but my broader point is simply this: Whatever the rule is going to be, it shouldn’t turn on whether the deal is structured as a merger or a tender offer.

Now, true, we haven’t seen a rash of gaming under the current regime, which - until the Ninth Circuit’s decision - already had different scienter requirements for 14(e) and 14a-9. That said, it must be recalled that Delaware didn’t start pushing these cases into federal court until 2015-ish; we may not have fully experienced the effects of divergent standards. In that sense, then, what Emulex is really doing is making the distinction more salient.

And what about this issue of private rights of action? Kevin LaCroix doubts the Court will eliminate the private right of action under 14(e) entirely, especially since no circuit court has even hinted at that possibility. But here’s the payoff: the Supreme Court doesn’t have to go all the way to holding that 14(e) provides no right of action to make an impact; all it has to do is say “We reserve for another day the question whether a private right of action exists under 14(e),” and we are off to the races. Expect a bunch of test cases, and a concerted, coordinated build of precedent in the lower courts, now more populated with Republican judges inclined to be skeptical of private claims. And that, I suspect, is really what the defendants, and the Chamber of Commerce, consider endgame.

*yes, yes, the phrase about “mak[ing] any untrue statement[s]” is also similar to the language of Rule 10b-5(b), which requires a showing of scienter, but that interpretation of 10b-5(b) is entirely due to the fact that 10b-5’s authorizing statute, Section 10(b), requires scienter; it’s not a standalone interpretation of the language of the rule.

Chief Justice Leo Strine of the Delaware Supreme Court just posted a fascinating article/speech to SSRN, which was apparently delivered to the Institute for Corporate Governance & Finance in November.

The subject of the speech is the fiduciary obligation that mutual funds owe fund beneficiaries when voting their shares, and in particular, the funds’ failure – in Strine’s view – to adequately police portfolio companies’ political spending.

The general thesis is that investors in mutual funds benefit most when the economy does well by generating long-term, sustainable jobs, and he lauds the current trend of mutual funds’ willingness to second-guess corporate managers and vote for measures that promote long-term sustainability, including their increasing willingness to back shareholder-sponsored proposals on ESG measures. As he puts it:

[I]nstitutional investors are not just getting involved in boardroom battles. … [S]ome prominent mutual funds have now expressed the view that their portfolio companies should act with sufficient regard for the law and general social responsibility. That is, in the area of corporate social responsibility, the largest institutional investors seem to be evolving in a positive direction.

He laments, however, that funds’ willingness to buck management appears to stop when it comes to political spending:

In the key area of corporate political spending, the Big 4 have opted for a policy of total deference to management…. [T]he Big 4 generally will not even vote to require corporations to disclose what they spend on politics, leaving the Big 4 and others largely blind to what is going on… [T]o be fair, State Street has done far better, supporting a majority of these proposals over the years….

In his view, political spending indicates that the corporation is seeking to profit by short-term regulatory arbitrage rather than by long-term investment in better products and services that will pay off more over time:

If a business has to try to make money by influencing the political process, that suggests that its prospects for growth by developing improved products and services are not strong. Instead, the business apparently has to seek special favors to gain access to subsidies or government contracts, not on the basis of the merits alone, but by currying favor…

He calls upon mutual funds to vote in favor of transparency regarding political spending, and even in favor of supermajority shareholder approval of political spending.

The usual argument in favor of these proposals is that they are in fact long-term wealth maximizing, as String acknowledges. But he also goes further and suggests that mutual funds should favor these proposals – and restrictions on political spending – even if they are not wealth maximizing in the corporate sense, out of respect for fund beneficiaries’ presumed shared interest in the safety of their jobs and the health of the environment. As he puts it:

Worker Investors derive most of their income and most of their ability to accumulate wealth, from their status as laborers, not as capitalists. ….Unless American public companies generate well-paying jobs for Worker Investors to hold, Worker Investors will not prosper and be economically secure….

[F]or diversified investors any increased profitability by particular corporations that results from externalities is suffered by them both as Worker Investors and as human citizens who pay taxes, breathe air, and have values not synonymous with lucre.

The colder economic term externalities can be put in the more human terms of dirtier water and air, workers who suffer death or harm at an unsafe workplace, employees whose health care needs to be covered by the government or a spouse’s more responsible employer, or defrauded or injured consumers. All of them are costs that Worker Investors bear as taxpayers, human victims, and as diversified investors. In other words, Worker Investors are not in on the swindle that results when an industry, think big tobacco, is able to make profits by shifting its costs of harm to others….

This is an extraordinary claim. He is placing workers’ shared desire for certain basic living standards on par with the hypothetical shared desire of all investors to maximize returns, and claiming that mutual funds have a duty to advance those interests.

Now, he’s not the first to make this argument (Other examples here and here). But I didn’t expect to hear it from Strine, and I have so many questions.

First, there is the issue of the factual basis for the argument. Some of those workers presumably are employed with big tobacco, or big oil, or coal, or any of the other industries where the desire for good jobs (or even the desire for affordable transportation) and environmental sustainability conflict. Shall we gloss over these distinctions (in the same way we do regarding the somewhat fictionalized concept of wealth maximization)?

Second, assuming he is correct, why is this a duty imposed on mutual funds and not the corporations directly? Strine has been a vocal champion of directors’ duties of wealth maximization; is he saying that mutual funds should be voting for policies that directors’ own duties prohibit them from advancing? I mean, obviously, the business judgment rule would prevent any kind of judicial second-guessing one way or another, but if we can talk theoretically about what mutual funds’ fiduciary duties require we can do the same for corporate directors.

Now, Strine (with co-author Nicholas Walter) has written before that if corporate political spending cannot constitutionally be constrained by regulation after Citizens United, then that suggests the shareholder wealth maximization norm must give way to a stakeholder theory of corporate obligation. (An argument that has also been made by others, including David Yosifon). Previously, though, I took him to mean that Citizens United should be overruled; should we now take him to be inching toward a reformed view of corporate law?

I obviously do not know whether anything more will come of this, but I look forward to future developments.

If you read this blog regularly, you know that one of my pet issues has been litigation limits in corporate charters and bylaws (examples here, here, and here).

The holy grail, for those who are in favor of these things, has been to insert clauses in corporate governance documents that would require all securities claims to be arbitrated on an individualized basis. The expectation has been that, given the Supreme Court’s recent jurisprudence, such provisions would pass muster under federal law.

In 2015, Delaware amended the DGCL to prohibit the insertion of arbitration clauses in corporate governance documents. But that statute explicitly applies only to “internal corporate claims,” Del. Code tit. 8, § 115, leaving open the possibility that it would not prohibit arbitration clauses that only govern federal securities claims.

One of the main stumbling blocks to that maneuver has been the SEC’s resistance – a resistance that recently has been crumbling.

The other stumbling block has been the possibility – which I’ve discussed repeatedly in blog posts, a law review article, and a book chapter (abstract only on SSRN; you have to buy the book for the rest!) – is that charters and bylaws can only govern internal affairs claims, and not external claims, including claims created by federal law.

The latter argument was finally tested in Delaware Chancery, but not in the context of arbitration. Rather, several companies went public with charter or bylaw provisions requiring that all Section 11 claims be litigated in a federal forum. That’s not arbitration, naturally, but it raises the same question whether charters and bylaws can govern federal securities claims.

I won’t quote the whole decision here, but I’ll just say, he has a lot of the same reasoning that I’ve previously laid out (and yes, he cited me, so, you know, yay! And it’s possible when the decision came down the first thing I did was a word search for my name LIKE YOU WOULDN’T DON’T JUDGE).

Second, I can imagine an effort to bypass charters and bylaws entirely, and simply to insert into a registration statement some kind of declaration to the effect that “all purchasers agree that federal securities claims/Section 11 claims are subject to such-and-such limits.” But that, of course, might be a bridge too far for the SEC, and even if it isn’t, I personally am unaware of any precedent for treating the registration statement as a “contract,” and thus there would be serious questions about whether purchasers could be bound in this manner.

Anything else I’m not thinking of? Feel free to speculate in the comments.

In any event, this is clearly my beat, so stay tuned for further developments.

What strikes me about the genre is how business-centric it seems to be. Though there are other types of plots (riffs on Cinderella/Roman Holiday/Sound of Music are always popular), a fairly common storyline is that there is some business that revolves around Christmas and is enjoyable for the townsfolk but relatively unprofitable. The characters have to find a way to make the business viable without turning it over to a soulless corporate operator who will lay everyone off and destroy its essential character. Typically, this involves teaching someone the true meaning of Christmas and the special value added to a company by longtime employees who put their hearts into their work.

It’s not that this is new, exactly; Christmas stories about profit-motive versus philanthropy trace back at least as far as Miracle on 34th Street (if not A Christmas Carol). But viewed through a business lens, Miracle on 34th Street is a tale of shareholder primacy. Of course, Santa didn’t care about profits; he only wanted to make children happy. But Macy’s managers discovered that they would generate more wealth if they adopted a pretense of generosity, which is why they embraced Santa’s strategy.

In other words, the goal is to create a sustainable business model that meets the needs of all stakeholders without conferring a fortune on anyone. I suppose we might call this the It’s a Wonderful Life view of business.

I posted about Lorenzo v. Securities & Exchange Commission when the SEC first granted certioriari; you can read my long thoughts about it here. Now that the Court held oral argument, I’ll offer my quick comments (and I’ll probably say still more when the decision comes down; this is a bountiful source of blogging material).

Picking up where I left off in my earlier post (I’ll assume you’ve either read that or are otherwise familiar with the issues in this case):

Lorenzo poses a quandary because the Supreme Court backed itself into a corner in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011). There, the Court narrowly construed what it means to “make” a statement for the purposes of Rule 10b-5(b), but then went further and suggested – via its invocation of Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) – that a wide range deceptive conduct falling outside of that definition not only would not involve making statements, but also would not be prohibited by Section 10(b) at all.

All of which has come back to bite the Court in Lorenzo. There, Lorenzo – acting with scienter – sent a deceptive email drafted by and attributed to his boss. And his argument is, he didn’t “make” a statement for Janus purposes, and if his conduct is considered otherwise deceptive or manipulative for Section 10(b) purposes, then Janus itself accomplishes nothing. Certainly, he didn’t commit any more of a deceptive act than the Janus defendants, and if their conduct didn’t fall within Section 10(b)’s prohibitions, well, then, neither did Lorenzo’s.

Based on the transcript, I’d tentatively say the Court is not inclined to buy Lorenzo’s argument. Counting heads is interesting here; the original Janus opinion was your typical 5-4 conservative/liberal split, but this time around one of the two new conservatives (Kavanaugh) is recused, because he was on the original panel that decided the case in the DC Circuit (where he sided with Lorenzo). Which means, if the Court breaks the same way it did in Janus, it would create a 4-4 split and affirm the lower court, handing at least a temporary win to the SEC.

That said, most of the questions were highly critical of Lorenzo, but, then, most of the questions came from the liberals who dissented in Janus, making it tough to use them as a gauge.

From the conservative side of things, Gorsuch was the only justice to offer a full-throated defense of Lorenzo’s position – one that was more effective than Lorenzo’s counsel, I’d add – but even with Gorsuch, I couldn’t tell if he was genuinely convinced or simply trying to articulate Lorenzo’s argument. Gorsuch basically laid out the claim that the only deceptive conduct here was the text of the email itself, and since Lorenzo was not the “maker” of that statement, he at best aided a deception, and did not himself engage in any deceptive conduct.

Roberts also defended Lorenzo, on the ground that the SEC’s position would render Janus a dead letter, but he didn’t talk much and, as with Gorsuch, he may have simply been offering the argument rather than stating his own position.

Alito, however – who was a member of the Janus majority – seemed convinced that Lorenzo’s act of knowingly sending a false email was sufficiently deceptive to violate Section 10(b). Which suggests the Court will ultimately rule in favor of the SEC with at least a 5-3 split.

That, however, puts the Court in the awkward position of reconciling a holding against Lorenzo with its Janus holding.

If I’m right about where the Court is going, it seems to me like there are a few potential paths. First, the Court can say that Janus was solely about interpreting 10b-5(b), and its references to Central Bank were irrelevant. This would mean that other kinds of conduct beyond “making” a statement (including the defendant’s conduct in the Janus case itself) may well violate Section 10(b) via 10b-5(a) or (c). If the Court goes that route, though, it is potentially broadening 10b-5 liability even for private plaintiffs, past what’s currently available now.

The second path would be to say that because Lorenzo included other verbiage in his email (like, directing clients to call him with questions), he functionally adopted the false statements and therefore became their “maker” even under Janus. This isn’t the position taken by the SEC but would be the least disruptive course of action for the Court.

(The Court could, I suppose, distinguish between private plaintiffs and the SEC but no one seemed interested in that possibility.)

A final path, I guess, would be to duck everything, say that Lorenzo violated Section 17(a), and that there is somehow no need to reach the Section 10(b) question. But no one offered that as a possibility, either, so I can’t tell if it’s something the Court is inclined to try.

Anyhoo, we’ll know by June, I suppose – so watch this space for updates.

Ann, as you may recall, has been focusing attention on the uncertain status of proxy advisors when it comes to liability for securities fraud. In her most recent post, she observes that

There’s a real ambiguity about where, if it all, proxy advisors fit within the existing regulatory framework, and while I am not convinced there is a specific problem with how they operate or even necessarily a need for regulation, I think it can only be for the good if the SEC were to at least clarify the law, if for no other reason than that these entities play an important role in the securities ecosystem, and if we expect market pressure to discipline them, potential new entrants should have an idea of the regime to which they will be subject.

I remember having similar questions as to the possible fiduciary duties and securities fraud liability of funding portals under the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (a/k/a the CROWDFUND Act)--Title III of the Jumpstart Our Business Startups Act (a/k/a/, the JOBS Act). I wrote about these ambiguities (and other concerns) in this paper, published before the SEC adopted Regulation CF. I know Ann's right that we have clean-up to do when it comes to the status of securities intermediaries in various liability contexts (a topic co-blogger Ben Edwards also is passionate about--see, e.g., here and here).

Bernie has honed in on voting process issues relating to both proxy advisors (the standard for making voting recommendations and the use/rejection of the same) and mutual fund investment advisers (the disclosure of mutual fund adviser voting procedures and SEC's enforcement of the Proxy Voting Rule). Specifically, in an October 12 letter to the SEC, Bernie sets forth three proposals on proxy advisor voting recommendations. His bottom line?

Institutional investors have a fiduciary duty to vote. However, the use of uninformed and imprecise voting recommendations as provided by proxy advisors should not be their only option. They should always be in a position of making an informed vote, whether or not a proxy advisor can help in making them informed.

Earlier, in an October 8 letter to the SEC (Revised as of October 23, 2018), Bernie recommends mutual adviser disclosure of "the procedures they will use to deal with the temptation to use their voting power to retain or acquire more assets under management and to appease activists in their own shareholder base" and "the procedures they will use to identify the link between support for a shareholder proposal at a particular company and the enhancement of that company’s shareholder value." He also recommends that the SEC "should clarify that voting inconsistent with these new policies and procedures or omission of such policies and procedures will be considered a breach of the Proxy Voting Rule" and engage in "diligent" enforcement of the Proxy Voting Rule. I commend both letters to you.

Ann's and Bernie's proxy disclosure and voting commentary also reminds me of the importance of co-blogger Anne Tucker's work on the citizen shareholder (e.g., here). It will be interesting to see what the SEC does with the information obtained through the proxy process roundtable and the related comment letters. There certainly is much here to be explored and digested.

[Postscript, 12/4/2018: Bernie Sharfman notified me this morning of a third comment letter he has filed--on proxy advisor fiduciary duties. It seems he may have a fourth letter in the works, too. Look out for that. - JMH]

On Wednesday, I had the great pleasure of delivering an address at the North American Securities Administrators Association’s annual training conference for its corporate finance division. I spoke about equity compensation for employees in private companies (you may recall that Joan linked to Anat Alon-Beck’s paper on that subject a couple of weeks ago). Equity compensation to employees is exempt from federal registration under Rule 701 – and the SEC is currently deciding whether to broaden that exemption – but is still subject to state regulation. Most states, however, simply follow the federal rules. The purpose of my talk was to discuss some of the risks posed to employee-investors when companies stay private for prolonged periods, and to suggest that state securities regulators may want to consider if there is a need for additional oversight.

Under the cut, I offer the (massively) abridged (but still probably too long) version of my remarks. For those interested in further reading on the subject, in addition to Anat’s paper highlighted by Joan, I recommend Abraham Cable’s excellent breakdown of the issues in Fool’s Gold? Equity Compensation and the Mature Startup.

As I mentioned at the time, one of the big issuer complaints about proxy advisors is that their recommendations may be erroneous – though of course, the definition of “error” is somewhat expansive and may include differences of interpretation. Issuer advocates have long sought some regulatory/statutory ability to review and, if possible, force revisions to proxy advisor reports before they are published, a proposal that – as I previously noted - apparently has found some sympathy with at least Commissioner Roisman.

From my perspective, though, the most interesting aspect to all of this is that if proxy advisors do, in fact, include false statements (however defined) in their recommendations, it is not entirely clear whether and to what extent they are subject to federal sanction.

The most obvious place to begin is Rule 14a-9, which prohibits false or misleading statements in proxy solicitations, and has generally been interpreted to apply to negligent, as well as intentional, false statements.

Well, ISS says yes, at least for its own recommendations, because ISS is a registered investment advisor. As such, it is subject to the antifraud provisions of the Investment Advisers Act, and is subject under that Act to a duty of care, including a duty to ensure the accuracy of its recommendations.

What if they’re both right: voting recommendations are neither proxy solicitations nor investment advice? Then neither 14a-9, nor the Investment Advisers Act, would apply to false statements in recommendations.*

We might then look to general prohibitions on false statements, articulated in Section 10(b) of the Exchange Act and Section 17 of the Securities Act. The problem is, both of these statutes only apply to statements made in connection with securities transactions. Proxy advisors, by definition, only provide voting advice, not advice regarding purchases and sales. Now, that may not matter: Section 10(b), for example, has been broadly extended to situations where the speaker might reasonably anticipate its statements would be used in connection with securities transactions, even if they weren’t specifically intended for that purpose. But then any legal action would focus on buying and selling rather than voting behavior. So it’s an unsettling gap: If proxy advisors are only providing voting advice, and their statements are not proxy solicitations, is there any clear legal prohibition on falsity?

My point is this: There’s a real ambiguity about where, if it all, proxy advisors fit within the existing regulatory framework, and while I am not convinced there is a specific problem with how they operate or even necessarily a need for regulation, I think it can only be for the good if the SEC were to at least clarify the law, if for no other reason than that these entities play an important role in the securities ecosystem, and if we expect market pressure to discipline them, potential new entrants should have an idea of the regime to which they will be subject.

So this is where I do think some action by the SEC would be helpful. Certainly, the SEC can decide whether proxy advisors’ voting recommendations qualify as proxy solicitations, and whether their conduct qualifies as investment advice (which might render unnecessary the proposed Senate Bill that would require proxy advisors to register as investment advisors). And if neither of these categories applies, the SEC might weigh in on whether and to what extent proxy advisors may be liable privately or subject to regulatory sanction for distributing false information in advance of an upcoming vote. And that alone, leaving aside other issuer complaints, would probably be useful going forward.

*Why the divergence in views as to whether proxy advice counts as investment advice? I assume the default is no one wants to claim a regulated status if they don’t have to, but ISS is particularly vulnerable to charges of conflict due to its consulting business; it may therefore feel that RIA status lends it an air of legitimacy that its clients find reassuring and that staves off additional regulatory pressure.

One thing I’ll note about the Roundtable is that it felt a lot like oral argument in an appellate court, in that everyone had fun expounding their positions but it’s not where the real policymaking gets done; that’s going to take place in back offices based on private meetings and written submissions, not in a public theater.

Still, I was interested in what everyone had to say. The webcast just went online here, but I’ll offer a summary of what stood out to me.

As I’ve posted about previously (here and here), Delaware is in the midst of a judicial reinterpretation of its appraisal statute, placing new emphasis on market pricing for determining the value of publicly traded stock. Currently, one open question is whether “market” pricing refers to the deal price, assuming the process was relatively clean, or the unaffected trading price of the stock.

First, they point out that apparently, Delaware courts only will consider trading price relevant to an appraisal action if price is efficient. But they argue that even prices of stock that trades inefficiently would serve as a better indicator of value than more traditional calculations like discounted cash flow, in part because there are many different types of “inefficient” markets and some will process the most important information about the company and produce a reasonably accurate price – perhaps with the judge adjusting for any information that was not assimilated. The test for market efficiency in an appraisal action is, in their view, too demanding.

Part of the reason I find this argument so interesting is that it mirrors the same kind of arguments we’ve been having in the fraud on the market space for over a decade, namely, how efficiently must the stock trade before plaintiffs are entitled to the fraud on the market presumption? In that context, just like Mitts and Macey, Donald Langevoort (among others) has argued that courts have demanded too high a standard of efficiency when a lesser one would do for the purposes of the inquiry – a point that the Supreme Court seems to have found persuasive. Of course, in the Section 10(b) context, we’re talking about informational efficiency; Mitts and Macey's argument depends on markets being efficient for fundamental value, or at least more accurate than other types of analysis.

The second argument that Macey and Mitts make is that the stock price reaction of the acquirer may indicate whether the deal price was too high, in which case, any appraised value should be lower. I.e., if the acquirer’s stock price drops in response to announcement of the deal, that would suggest that the market believes the target was overvalued. That’s a really clever suggestion, though I do wonder about their argument that the analysis holds even for private targets – we might legitimately ask whether the market knows enough about private targets to make an informed assessment of the appropriateness of the deal price and the target’s effect on the acquirer’s value.

Of course, overall, their argument would push Delaware’s law even further toward eliminating appraisal for all but the most egregious cases; in recent years, many scholars have argued that appraisal can be used as a kind of substitute for a broken system of fiduciary duty litigation. Macey and Mitts believe that if fiduciary litigation is broken, it should be fixed, rather than substituting in a different cause of action to do that work.

Yesterday, I had the pleasure of participating in Case Western Reserve Law Review Conference and Leet Symposium, Fiduciary Duty, Corporate Goals, and Shareholder Activism. It was a fun and lively set of discussions with some interesting themes that hit right in my sweet spot of interests, so I had a wonderful time. I’ll give a brief synopsis of the topics under the cut, but the entire thing will soon be available as a webcast online at the above link, and next year the law review will publish a special symposium issue.

Also, I just apologize in advance if I misdescribe anyone’s remarks – if you see this post and want to correct me, feel free to send an email.

Daniel Greenwood coined the term “fictional shareholders” to refer to courts’ tendency to base corporate law decisions on the preferences of a set of hypothetical investors, untethered to the real-world priorities of the actual shareholders who hold a company’s stock. See Daniel J.H. Greenwood, Fictional Shareholders: “For Whom Are Corporate Managers Trustees,” Revisited, 69 S. Cal. L. Rev. 1021 (1996). If ever there were an illustration of Greenwood’s point, it comes in VC Laster’s recent post-trial decision in In re PLX Stockholders Litigation.

If you follow this blog regularly, you’ve probably seen me rant about the myriad errors courts make when evaluating market and investor behavior in the context of securities litigation. I finally did what I’d been threatening to do and compiled my complaints into a single Essay on the subject, which I presented at the Connecting the Threads symposim hosted by the University of Tennessee at Knoxville in September. (The symposium featured all of the Business Law Prof bloggers, and Marcia posted a description of the full program here)

My Essay, along with pieces by my co-bloggers, will be published in Transactions: The Tennessee Journal of Business Law. I’ve just posted a draft to SSRN, and – anyway, here’s Wonderwall:

Abstract: Courts entertaining class actions brought under Section 10(b) of the Securities Exchange Act are required to make numerous factual judgments about the economic effects of the alleged misconduct. For example, they must determine whether and for how long publicly-available information has exerted an influence on security prices, and whether an alleged fraud caused economic harm to investors. Judgments on these matters dictate whether cases will proceed to summary judgment and trial, whether classes will be certified and the scope of such classes, and the damages that investors are entitled to collect.

Over the years, courts have developed a variety of common law doctrines to guide these inquiries. As this Essay will demonstrate, collectively, these doctrines operate in such an artificial manner that they no longer shed light on the underlying factual inquiry, namely, the actual effect of the alleged fraud on investors. The result is that determinations of market impact and investor loss have become, in a real sense, fictional: the size and effects of the fraud are determined based on abstract doctrine rather than any empirical assessment of market behavior. Ultimately, these stylized approaches to assessing market evidence interfere with the ability of the Section 10(b) cause of action to fulfill its modern function as a mechanism for deterring fraud.

This Essay therefore recommends that, to the extent possible, these inquiries should be replaced with alternative schemes that award damages based on some combination of statutory formulas and evidence of investors’ reliance on the fraud. These alternatives would be easier for courts to administer, and would re-align the fraud-on-the-market action with its fundamental goals.

This week, the Delaware Supreme Court decided Flood v. Synutra, and began to clear up some of the questions left open after its earlier decision in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”). Flood itself is relatively straightforward but, for me, it inevitably calls to mind some larger issues regarding the relationship between independent directors and controlling shareholders under Delaware law.

For many years, the regime in Delaware was that a controlling shareholder squeeze-out transaction would be reviewed for entire fairness, but the burden to prove lack of fairness would be placed on plaintiffs if the deal was approved by either a majority of the minority shareholders, or by a committee of independent directors who acted freely, without coercion, had the power to say no, etc. See Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).

In MFW, the Delaware Supreme Court held that if a controlling shareholder employs both protections, and makes clear from the outset that any deal will be conditioned on their satisfaction, and there is no reason to think the protections were circumvented (i.e., the committee acted with care, was fully empowered, and so forth), the resulting deal will get business judgment review. But a lot was still left open.

For one thing, MFW had this odd footnote that suggested that an independent committee’s lack of care/bargaining power might be demonstrated, for pleading purposes, by a showing that the deal price was insufficient. The footnote was odd because normally a lack of care is not pled by challenging a substantive outcome; allowing it in this instance suggested the Court was not entirely confident that MFW’s dual protections truly substituted for an arm’s-length deal. And for another thing, MFW did not specify how early in the process the controller would have to disable itself to be entitled to business judgment protection.

So in Flood, per Chief Justice Strine, the Court began to close the holes.

First, it basically did away with MFW’s baffling footnote, which to be honest is more housekeeping than anything else.

And second, the Court held that “so long as the controller conditions its offer on the key protections at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”

In other words, a controlling shareholder may still take advantage of the MFW framework if it proposes the deal without the protections, and adds them later, so long as no “substantive economic negotiations” (and possibly other steps) have taken place in between.

Justice Valihura, in dissent, argued that the majority’s rule would inevitably draw courts into factual disputes as to what constitutes “substantive economic negotiations.” (And I admit, even I’m unclear what happens if the deal is proposed, and the special committee hires advisors and conducts due diligence without any negotiations, but before the conditions are added). Valihura would have preferred that the MFW rule kick in only if the conditions appear in the first formal written proposal (with, it must be said, exceptions if plaintiffs can show there was intentional evasion via oral negotiations before that point – so factual disputes are always possible).

Which brings me to the issue of independent directors.

In Flood, the controlling shareholder submitted a letter proposing a deal without either of MFW’s protections. Over the next two weeks, a new independent director – one previously proposed by the controller – was added to the Board, a special committee was formed to consider the proposal, and the newly-added director was placed on that committee. Also (and this was the focus of the Valihura dissent) there were other arrangements involving each side hiring counsel, and the directors being briefed on their fiduciary duties. After that, the controller submitted a revised letter conditioning the deal on the MFW protections. Despite the intervening events between the first proposal and the revised letter, the majority held that the MFW framework would apply. The majority was untroubled by the new addition to the Board, or his presence on the special committee. In other words, the Court was confident that, even under these circumstances, he could perform his duties fairly.

So here’s why this all strikes me as odd.

It has never been entirely clear whether the Delaware Supreme Court believes that independent directors can be trusted to stand up to controlling shareholders.

In Kahn v. Lynch, the Court held that squeeze out mergers would get entire fairness review even if approved by independent directors who acted diligently, fairly, etc. But it did not justify its holding on the ground that independent directors are likely to be coerced by a controller; rather, it only explicitly said that minority shareholders might feel coerced. Standing alone, then, Kahn might be interpreted to mean that since mergers ordinarily have dual protections (disinterested director plus disinterested shareholder approval), then if only one is present (disinterested director approval), there must be heightened scrutiny, with no suggestion that independent directors are likely to bow to a controller’s wishes.

Subsequent Chancery cases – including one authored by Chief Justice Strine when he was Vice Chancellor – interpretedKahn to mean that independent directors might be cowed by the presence of a controller, and therefore their decisions are suspect. See, e.g., In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002) (where then-VC Strine characterized controllers as 800-pound gorillas). As a result, a series of Chancery cases have subjected controlling shareholder transactions to entire fairness review, even if approved by the independent directors, and even if the transaction wouldn’t ordinarily require shareholder approval. See discussion in In reEzcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016).

In other words, Chancery courts seem (?) to have coalesced around the view that controlling shareholders are likely to overwhelm both stockholders and independent directors, and therefore we can only trust the fairness of an interested-controller transaction if both approve, without any additional evidence of coercion.

If I’m not mistaken, the Delaware Supreme Court did eventually explicitly endorse the idea that directors can never be truly independent of a controller, but only twice. In Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997), the Court held:

Entire fairness remains applicable even when an independent committee is utilized because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny….The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder. Consequently, even when the transaction is negotiated by a special committee of independent directors, no court could be certain whether the transaction fully approximated what truly independent parties would have achieved in an arm's length negotiation.

(quotations and alterations omitted). Later, the Court said the same thing in Ams. Mining Corp. v. Theriault, 51 A.3d 1213 (Del.2012), quoting Tremont. But these cases are the only ones that I know of where the Delaware Supreme Court explicitly said that we cannot fully trust even independent directors when they stand opposite controlling shareholders. And I note that earlier cases held in dicta that independent directors could cleanse transactions involving controlling shareholders. See, e.g., Summa v. Trans World Airlines, Inc., 540 A.2d 403 (Del. 1988); Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993).

(Am I wrong? Is there another case where the Delaware Supreme Court was explicit about the fact that independent directors should be distrusted as a matter of law – even absent a showing of some specific dysfunction – when across the table from a controlling shareholder?)

But if that’s right, there’s an odd incongruity, which Vice Chancellor Laster explored in detail in In reEzcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016), and that then-Vice Chancellor Strine flagged in In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002). Namely, it is well-established that independent directors are presumed to be unbiased for the purposes of the demand requirement in a derivative lawsuit, even if the defendant is a controlling shareholder. In other words, we always trust that independent directors can make a fair determination as to whether it is in the corporation’s interest to file a lawsuit against the controller. That much goes back to Aronson v. Lewis, 473 A.2d 805 (Del. 1984).

So now here we are, back in the context of a controlling shareholder squeeze-out, and we have a prima facie reason to distrust the decisionmaking of the independent directors: A whole new one was added to the board, at the controller’s behest, and added to the special committee, after the controller had proposed the deal.

But does the Court suspect wrongdoing? No! To the contrary, it cites Aronson – the original case to hold that independent directors are unlikely to be cowed by controllers – to justify its faith in the directors’ fortitude. See Flood, slip op. at 8 n.37. The Court does not invoke Tremont, with its explicit doubts whether independent directors can resist controllers.

Point being, which is it? Do we trust independent directors to protect minority shareholders when their interests diverge from the controller, or don’t we? If we do, then MFW should only apply in the context of transactions that legally cannot be consummated without both director and shareholder approval; if the transaction does not require both, approval by independent directors should be sufficient. And if we don’t trust independent directors to stand up to controllers, then MFW should apply to all situations where a controlling shareholder has interests that diverge from the minority, including determinations of whether demand is futile. And if we don’t fully trust independent directors to defy controlling shareholders, we should be much more suspicious of squeeze-outs that are initiated without the MFW protections, even if the directors only engage in minimal preparations before those protections are added. Or perhaps the demand requirement is its own separate world - which is what VC Laster seemed to think in Ezcorp - in which case, Aronson should not be used to support an inference of director independence in other contexts.

Anyhoo, these incongruities have persisted for many years; it’s quite possible they’ll continue for many years more, and I guess we’ll have to live with the uncertainty for now.

BLPB reader Tom N. sent me a link to this article last week by email. The article covers Elon Musk's taunting of the U.S Securities and Exchange Commission (SEC) in a post on Twitter. The post followed on the SEC's settlement with Musk and Tesla, Inc. of a legal action relating to a prior Twitter post. The title of Tom N.'s message? "Musk Pokes the Bear in the Eye." Exactly what I was thinking (and I told him so) when I had read the same article earlier that day! This post is dedicated to Tom N. (and the rest of you who have been following the Musk affair).

Last week, I wrote about scienter issues in the securities fraud allegations against Elon Musk, following on Ann Lipton's earlier post on materiality in the same context. This week, I want to focus on state corporate law--specifically, fiduciary duty law. The idea for this post arises from a quotation in the article Tom N. and I read last week. The quotation relates to an order from the judge in the SEC's action against Musk and Tesla, Alison Nathan, that the parties jointly explain and justify the fairness and reasonableness of their settlement and why the settlement would not hurt the public interest. Friend and Michigan Law colleague Adam Pritchard offered (as quoted in the article): “She may want to know why Tesla is paying a fine because the CEO doesn’t know when to shut up.” Yes, Adam. I agree.

What about that? According to the article, the SEC settlement with Musk and Tesla "prevents Musk from denying wrongdoing or suggesting that the regulator’s allegations were untrue." The taunting tweet does not exactly deny wrongdoing or suggest that the SEC's allegations against him were untrue. Yet, it comes close by mocking the SEC's enforcement activities against Musk and Tesla. Musk's action in tweeting negatively about the SEC is seemingly--in the eyes of a reasonable observer--an intentional action that may have the propensity to damage Tesla.

At the very least, the tweet appears to be contrary to the best interests of the firm. But is it a manifestation of bad faith that constitutes a breach of the duty of loyalty under Delaware law? As most of us well know,

[b]ad faith has been defined as authorizing a transaction "for some purpose other than a genuine attempt to advance corporate welfare or [when the transaction] is known to constitute a violation of applicable positive law." In other words, an action taken with the intent to harm the corporation is a disloyal act in bad faith. . . . [B]ad faith (or lack of good faith) is when a director acts in a manner "unrelated to a pursuit of the corporation's best interests." It makes no difference the reason why the director intentionally fails to pursue the best interests of the corporation.

Bad faith can be the result of "any emotion [that] may cause a director to [intentionally] place his own interests, preferences or appetites before the welfare of the corporation," including greed, "hatred, lust, envy, revenge, . . . shame or pride."

In Re Walt Disney Co. Derivative Litigation, 907 A.2d 693, 753-54 (Del. Ch. 2005). Of course, Musk was not authorizing a transaction--or even clearly acting for or on behalf of Tesla--in making his taunting tweet. But he is identified strongly with Tesla, and his tweet was intentional and inconsistent with the best interests of the firm. Did he intend to harm Tesla in posting his tweet? Perhaps not. Did he act in a manner "unrelated to a pursuit of the corporation's best interests?" Perhaps. The tweet is certainly an imprudent (and likely grossly negligent or reckless) action that appears to result from Musk intentionally placing his own hatred or revenge ahead of the interests of Tesla.

"To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation." Id. at 755. Yet, it is unclear how far that goes in a Twitter-happy world in which the personal blends into the professional. Musk was (in all likelihood) not taking action as a director or officer of Tesla when he tweeted his taunt. Yet, he was undoubtedly cognizant that he occupied those roles and that his actions likely had an effect on the firm. Should his fiduciary duties extend to this type of conduct?

And what about the Tesla board's duty to monitor? Does it extend to monitoring Musk's personal tweeting? E.g., the argument made in the Chancery Court's opinion in Beam Ex Rel. Martha Stewart Living Omnimedia, Inc. v. Stewart. Even of not mandated by fiduciary duty law, the SEC clearly wants the board to have that monitoring responsibility. The settlement with the SEC reportedly provides for "Tesla’s board to implement procedures for reviewing Musk’s communications with investors, which include tweets." More for us all to think about when we think about Elon Musk and Tesla . . . . It's always best not to poke the bear.

All I’ve got this week is a drive-by of interesting things (which is necessary because of how the news was so. exceptionally. boring)

1) You’ve probably at least heard about the New York Times’s massive expose on Donald Trump’s inherited wealth and the tax fraud that enabled it. If you’re not a tax person, the length may be a little intimidating, but trust me it’s very accessible and worth the read. Among other highlights are some specific descriptions of the use of a shell company called All County Building Supply & Maintenance that served a dastardly dual purpose: to spin cash gifts from Fred Trump to his children into ordinary income (thus avoiding gift tax liability), and to justify rent increases for rent-stabilized apartments. Fred Trump accomplished this by making his children owners of All County, and then using All County as a purchasing agent for his buildings. For every purchase, All County added a large markup – pure profit for All County (and thus the kids), paid by Fred Trump. Then, Fred Trump used the inflated bills as proof of property improvements to justify his rent increases. The scheme was sheer elegance in its simplicity.

For the securities aficionados, the article also has a soupcon of market manipulation: Fred Trump would buy stock in companies just before Donald Trump leaked an intention to take them over, causing a quick boost in the stock price.

2) Another expose, this one from the Washington Post, on the fate of small investors in Trump hotels. These investors bought individual units as condominiums, in the expectation that the Trump organization would rent them out and, after deducting maintenance fees, pay them the income. Problem is, after 2016, business has plummeted in New York and Chicago, leaving these investors with large losses. An interesting tale of corporate governance and, if you like, a timely hypothetical regarding application of the Howey test to condo sales. (Also, for those interested in reporting process, here is a Tweet thread explaining how WaPo developed the story.)

3) Finally, I previously posted about a pending oral argument in Delaware Chancery on the question whether corporate charters and bylaws can impose litigation limits (forum selection clauses, etc) on federal securities claims, in addition to placing limits on Delaware internal affairs claims. That argument, in the case of Sciabacucchi v. Salzberg, 2017-0931, took place on September 27, and the transcript is available from the Chancery court reporters. Attorneys did most of the talking, but towards the end of the hearing, VC Laster honed in on the critical question: if charters and bylaws can extend to cover claims not governed by Delaware law or the internal affairs doctrine, how much further can they go? William Chandler – yes, that William Chandler, former Delaware Vice Chancellor, now with Wilson Sonsini – argued that they extend to any claim that deals with the stockholder’s rights as a stockholder; VC Laster expressed concern about defining the appropriate relationship between the claim and the plaintiff’s stockholder status. At the same time, he acknowledged that ultimately the issue will probably be resolved not by him, but by the Delaware Supreme Court.

I have been so grateful for Ann Lipton's blog posts (see here and here) and tweets about Elon Musk's going-private-funding-is-secure tweet affair. Her post on materiality on Saturday--just before the SEC settlement was announced--was especially interesting (but, of course, that's one of my favorite areas to work in . . .). She tweeted about the settlement here:

[Note: this is a screenshot.] Ann may have more to say about that in another post; she did add a postscript to her Saturday post reporting the settlement . . . .

But I also find myself wondering about another of the contentious issues in Section 10(b)/Rule 10b-5 litigation: scienter. This New York Times article made me think a bit on the point. It tells a tale--apparently relayed to the U.S. Securities and Exchange Commission (SEC) in connection with its inquiry into the tweet incident--of fairly typical back-room discussions between/among business principals. This part of the article especially stuck with me in that regard:

On an evening in March 2017, . . . Mr. Musk and Tesla’s chief financial officer dined at the Tesla factory in Fremont, Calif., with Larry Ellison, the chairman of Oracle, and Yasir Al Rumayyan, the managing director of the Saudi Public Investment Fund. During the meal, . . . Mr. Rumayyan raised the idea of taking Tesla private and increasing the Saudi fund’s stake in it.

More than a year later, . . . Mr. Musk and Mr. Rumayyan met at the Tesla factory on July 31. When Mr. Rumayyan spoke again of taking the company private, Mr. Musk asked him whether anyone else at the fund needed to approve of such a significant deal. Mr. Rumayyan said no . . . .

Could Musk have actually believed that a handshake was all that was needed here? We all know a handshake can be significant. (See here and here for the key facts relating to the now infamous Texaco/Getty/Pennzoil case.) But should Musk have taken (or at least should he have known that he should take) more care to verify before tweeting? In other words, can Musk and his legal counsel actually believe they can prove that Musk (1) had no knowledge that his tweet was false and (2) was merely negligent--not reckless--in relying on the oral assurance of a business principal to commit to a $70+ billion transaction?

Don Langevoort has written cogently and passionately about the law governing scienter. One of my favorite articles he has written on scienter is republished in my Martha Stewart book. What he urges in that piece is that the motive and purpose of a potentially fraudulent disclosure are not the relevant considerations in determining the existence of scienter. Rather, the key question is whether the disclosing party (here, Musk) knew or recklessly disregarded the fact that what he was saying was false. Join this, Don notes, with the securities fraud requirement that manipulation or deception be in connection with the purchase or sale of a security, and the test becomes not merely whether Musk misrepresented material fact or misleadingly omitted to state material fact, but also whether he could reasonably foresee the likely impact of his misrepresentation on the market for Tesla's securities.

On the one hand, as Ann points out in her post on Saturday, a number of investors in the market thought the tweet was a joke. Given that, might we assume that Musk--a person perhaps similarly experienced in finance--knew or should have known that his tweet was false? On the other hand, as Ann notes in her post, the SEC's complaint states that "market analysts - sophisticated people - privately contacted Tesla’s head of investor relations for more information and were assured that the tweet was legit. So that’s evidence the market took it seriously." Yet, Musk might just be presumptuous enough to believe he could reasonably rely on an oral promise by a person who is in control of executing on that promise--thinking it represented a deal (although, of course, not one that experienced legal counsel would understand to be legally, or even morally, binding or enforceable). Too wealthy men jawing about a deal . . . .Puffery, or the way business actually is done in this crowd?

Based on what I know today (which is not terribly much), my sense is that a court should find that Musk acted in reckless disregard of the falsity of his words and understood the likely impact those words would have on the trading of his firm's stock. To find otherwise based on the specific facts alleged to have occurred here would inject too much subjectivity into the (admittedly subjective) determination of scienter. But we shall see. As Ann noted in Saturday's post, a private class action also has been brought against Musk and Tesla based on the tweet affair. So, we may yet see the materiality and scienter issues play themselves out in court (although I somehow doubt it).

By now, I’m sure everyone’s seen the eyebrow-raising SEC complaint filed against Elon Musk for his fateful tweet announcing “funding secured” for his plan to take Tesla private at $420/share – while keeping all the old shareholders. There are a lot of juicy details here, including an allegation that the $420 price was – as many suspected – a reference to marijuana; he ballparked a 20% premium, which would bring the price to $419, and then rounded up to impress his girlfriend.

Well, as we all know by now, funding was not secure, there was no plan, and – as I previously posted – there was no way the plan was ever going to work in the first place, because you can’t go private while keeping a massive retail shareholder base.

That said, the thing I keep wondering is, if anyone but the SEC had brought this case, would there be a serious question of materiality?

For starters, there has been a private complaint. A short-seller, apparently injured when Tesla’s price shot up in the wake of Musk’s initial tweet, filed a class action complaint alleging securities fraud. Now, this case is in the early stages so there’s no way to tell exactly where it will go, but I first note that even though a short-seller filed the complaint, the class appears to consist of people who went long – who bought in on the tweet, and lost money when it became clear that no take-private deal would be forthcoming.

Why?

Well, short-sellers occupy a kind of weird position in Section 10(b) cases, especially for a scenario like this. They borrow shares, sell them, and lose money if they have to return the borrowed shares by repurchasing at a higher price. If the allegation is that the company’s lies forced them to cover at a higher price than they otherwise would have – i.e., if the lies happened after the initial sale – there may not be any reliance in the traditional sense. That is, the seller may not have necessarily believed the lie, but might have been forced to cover anyway. Courts have been a bit inconsistent in how these claims are treated, see Rocker Management, LLC v. Lernout & Hauspie Speech Products N.V., 2007 WL 2814653 (D.N.J. 2007) (discussing cases), and Basic v. Levinson, 485 U.S. 224 (1988) suggests that forced transactions made while knowing the truth are not in reliance on the fraud – so it is not clear that under existing doctrine, a short-seller who saw through the lie almost immediately, but was injured because other people didn’t, has a Section 10(b) claim. (It’s not impossible that Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398 (2014) will change how courts think about these things; in that case, the Supreme Court was explicit that reliance exists for traders who disbelieve the market price but expect it to eventually correct; the Court was not talking about short-sellers, but the logic might extend that far).

But anyway! Leaving aside the short-seller bit for a moment, the problem from a materiality standpoint is that the market saw through the lie almost immediately.

We start with the definition of materiality: a fact is material if there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” Basic, 485 U.S. at 231-32. Well, would a reasonable shareholder have taken Musk’s statement seriously? Musk has a history of bizarre tweets, so on the day the fatal tweet issued, people were speculating it was a joke. For example:

To be sure, with respect to this argument, one of the best points in the class’s favor is a nugget in the SEC complaint that market analysts - sophisticated people - privately contacted Tesla’s head of investor relations for more information and were assured that the tweet was legit. So that’s evidence the market took it seriously.

That said, as I explained in my prior post, the structure Musk proposed was legally impossible – indeed, his failure even to investigate the legality is a central factor in the SEC’s complaint. But those legal standards are publicly known, and thus are part of the “total mix of information made available.” See, e.g., Wielgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989) (“Issuers needn’t print the Code of Federal Regulations…”). So, one might argue – especially in the fraud-on-the-market context, where truths might have an offsetting impact on market price – that the truth about the impossibility of Musk’s plan was necessarily known to investors and could not have impacted the stock’s price.

Aha, you might say – but the tweet did impact the stock’s price – it closed up nearly 11%! Market reaction was so volatile that the NASDAQ had to temporarily suspend trading! Isn’t that proof of materiality?

That said, whatever challenges these issues might pose for private plaintiffs, it’s not clear they’ll get much traction in the context of a governmental action, where, rightly or wrongly, courts often treat materiality differently than they do in the private-litigation context. Cf. Margaret V. Sachs, Materiality and Social Change: The Case for Replacing “the Reasonable Investor” with “the Least Sophisticated Investor” in Inefficient Markets, 81 Tul. L. Rev. 473 (2006) (describing some cases). However, Musk reportedly already rejected an SEC settlement and – Musk being Musk – might be determined to fight this thing all through trial, so I’m curious to see how it plays out.

Edit: Well, doesn’t look like we'll get a chance to find out, because Musk backed down and agreed to settle with the SEC after all. We might see these arguments play out in the private action, though - and while I don’t actually expect a court to dismiss on materiality grounds (the market furor was just too great to ignore), the fact that these arguments are even available in the doctrine highlights, to me, a point I’ve emphasized in this space before: concepts of materiality, loss causation, market efficiency and so forth have become stylized to the point of fiction.

[T]here’s a subtext in all of this, and it’s that Shari Redstone in particular is an untutored interloper, interfering in a business that she knows little about having finally managed to wrest control from her ailing – and often-estranged – father….It’s hard not to wonder about something of a gendered undercurrent in this kind of commentary, and that, in turn, taints CBS’s general depiction of Shari Redstone as a gossipy – and they don’t use that word but that is the implication when they allege that Redstone basically is saying mean things about people – busybody in corporate affairs.

In light of what transpired and came to light since then, I’m going to emphasize that point again. Because there’s even more evidence today that the Board’s hostility to Redstone – and its support of Moonves – was tainted by (what I assume was unconscious) bias. And now, after an expensive and pointless legal battle, terrible publicity, and a general waste of corporate resources, we have a cautionary tale about how sexism distorts and inhibits business judgment.